Combat Under-Reporting of Income on Accounts and Entities in Offshore Jurisdictions
In recent years, members of Congress, many commentators, and the IRS have expressed growing concerns about Americans evading U.S. taxes by hiding assets in foreign bank accounts. U.S. citizens and residents with foreign accounts have long been required to file annual reports with the Treasury on these accounts (the notorious FBAR), and the IRS has recently redoubled its efforts to enforce this requirement. The U.S. government’s efforts to obtain information about U.S. clients of the Swiss bank, UBS, have often been in the news, as have the criminal prosecution and imprisonment of a former UBS employee who supplied the government with some of its initial leads in the case. During 2009, the IRS offered a limited amnesty to taxpayers voluntarily disclosing offshore accounts. Probably because of the publicity given to the FBAR requirement and the USB case, the amnesty offer was reportedly accepted by hundreds of taxpayers.
The president proposes to strengthen and add to the IRS’s tools for combating offshore evasion. According to the Treasury’s Green Book, “For too long, some Americans have evaded their taxpaying responsibilities by hiding unreported income in a foreign bank account, trust, or corporation.” These proposals are intended to “reduce such evasion.” All of them are amendments to existing procedural rules, intended to strengthen the IRS’s ability to uncover information about offshore accounts of American taxpayers. None of the proposals is self-executing. They will advance the goal of reducing tax evasion only if backed up with substantial investments of IRS resources, but with adequate effort from the IRS, the proposals could make a significant contribution toward the goal.
Qualified intermediaries. Since 2000, the IRS has had a program of making agreements with foreign financial institutions, mostly banks, that agree to serve as “qualified intermediaries” (QIs). A QI agrees to collect, process, and document information from its customers on U.S. source income that it receives for the customers. The principal documentation is an IRS prescribed “withholding certificate,” by which the customer certifies whether he or she is a U.S. citizen or resident and, if not, whether the customer qualifies for reduced U.S. withholding tax. The benefit for a foreign financial institution is that a QI agreement allows the institution to determine the correct amounts of U.S. withholding taxes, thereby relieving its customers of the burden of filing for refunds of excess withholding taxes. For example, dividends paid by U.S. companies to foreign investors are subject to a withholding tax at a statutory rate of 30 percent, but if the investor resides in a country with a tax treaty with the United States, the tax is reduced to 15 percent. To get the 15 percent rate, the investor must either establish treaty residence in advance or file for a refund from the IRS after the fact. By making a U.S. investment through a QI, a foreign investor can, for example, establish entitlement to withholding at treaty rates without revealing information about himself or herself to U.S. tax authorities or any other person within the United States. A major benefit of the QI program for the IRS is that a QI must identify American investors receiving U.S. source income through the QI.
The president proposes several significant changes to the QI program. First, to increase pressure on foreign financial institutions (FFIs) to become QIs, the proposals would require an American financial institution or other U.S. firm to withhold a 30-percent tax from any payment it makes to an FFI other than a QI of (1) U.S. source dividends, interest, rents, or royalties or (2) gross proceeds from sales of stock or debt instruments of U.S. companies. If an FFI becomes a QI, in contrast, it has two options. It can undertake all U.S. withholding obligations for its clients, thus allowing it to receive payments from American institutions and firms free of all withholding. Alternatively it can assume a documentation role, in which case American institutions and firms will withhold from payments to the FFI to satisfy the actual U.S. tax obligations of the FFI’s clients, as determined by the FFI. Because foreign investors in U.S. securities are generally not subject to U.S. capital gains taxes, no U.S. tax is withheld from sales proceeds received by a QI for a foreign client. The U.S. tax on a foreign investor’s dividend or interest income is often less than 30 percent, and withholding on such income of foreign clients of a QI is at the actual rate, not the flat 30 percent.
Currently, a QI is only obligated to collect information on U.S.-source investment income of its customers, even for customers who are U.S. citizens or residents. The proposal would require a QI to identify accounts of U.S. citizens, residents, and companies, regardless of where the accounts are invested. A QI would also have to identify accounts of any foreign entity in which a U.S. citizen, resident, or company owns more than a 10 percent interest. A QI could satisfy these requirements by either providing detailed information about the accounts or filing Forms 1099 reporting income and sales proceeds credited to the accounts on a worldwide basis. A QI choosing the latter alternative would essentially function like a U.S. bank with respect to its U.S. customers. These reporting obligations would apply to accounts with other members of a QI’s “expanded affiliated group,” as well as accounts with the QI itself. An FFI thus could not avoid reporting on accounts of U.S. customers isolating the accounts in an entity separate from the entity that handles U.S. investments of non-U.S. customers and has a QI agreement with the IRS.
These proposals could potentially provide potent weapons in the IRS’s war on offshore tax evasion. By adding to the IRS’s ability to gather information on accounts with full-service FFIs, the proposals would encourage Americans determined to hide assets from the tax collector to use foreign financial intermediaries that do not serve non-U.S. clients investing in the United States and thus have no incentive to become QIs. The proposals would not, for example, affect a foreign firm organized to make non-U.S. investments for U.S. clients. At a minimum, however, the proposals would discourage offshore tax evasion by making it more expensive.
Because they would add significant administrative burdens for both current and new QIs, as well as the IRS, the proposals will likely encounter substantial opposition from the financial community. Because of these burdens, the proposals would not become effective until 2013.
U.S. income received through foreign intermediaries other than financial institutions. The president further proposes to require U.S. financial institutions and companies to withhold a 30-percent tax from U.S. source dividends, interest, rents, or royalties or proceeds of sales of stock or debt instruments of U.S. companies paid to foreign entities other than financial institutions. This withholding tax would not apply—and the usual withholding rules would apply—if (1) the entity either certifies that no U.S. citizen, resident, or company owns more than 10 percent of the entity or provides the name, address, and taxpayer identification number of each U.S. citizen owning such an interest and (2) the person making the payment does not know or have reason to know that any of certified information is incorrect. The proposal, effective for payments made after 2012, would complement the proposals on payments to foreign financial institutions described above. It would, for example, apply to a foreign trust created by a U.S. citizen to invest in the United States. Unlike the QI rules, it would not require reporting by a foreign entity because the U.S. government has no power to enforce a reporting requirement in this context. Because of this limitation, the proposal would do nothing to curb evasion by Americans hiding foreign assets in foreign entities.
Foreign-targeted bearer bonds. The United States has long imposed several tax penalties on issuers and holder of bearer bonds (bonds with respect to which the issuer does not maintain a registry of recognized owners). For example, an issuer is allowed no deduction for interest on bearer bonds and must pay an annual excise tax of one percent of the principal amount for each year in the bonds’ term, and for foreign holders, the exemption of “portfolio interest” from U.S. withholding taxes does not apply to interest on the bonds. Congress adopted these penalties because bearer bonds are incompatible with the information reporting system on which the United States relies to enforce taxation of investment income. Under current law, the tax penalties do not apply to a bearer bond if interest on the obligation is payable only outside the United States and the written evidence of the obligation bears a legend stating that a U.S. citizen holding the obligation is “subject to limitations under the United States income tax laws.” Congress provided this exemption to allow U.S. companies to issue bearer bonds in foreign markets to foreign investors, to whom the U.S. information reporting system does not apply. Over the years, as capital markets have become more globalized, it has become easier for U.S. taxpayers to acquire these foreign-targeted bearer bonds and use them to evade U.S. taxes with little fear of detection. The president proposes to eliminate the exemption, effective for obligations issued more than two years after the repeal is enacted into law. The proposal would probably make a small contribution to the war against offshore tax evasion.
Tax return disclosure of foreign accounts. Under current law, a U.S. citizen or resident must indicate on his or her tax return whether he or she has an interest in a foreign bank account, and if the person has foreign accounts with an aggregate balance of at least $10,000 at any time during the year, he or she must also file with the Treasury a separate Report of Foreign Bank and Financial Accounts, commonly known as the FBAR. A large penalty attaches to a failure to file the FBAR, but there is no specific penalty for failing to check the box on the tax return indicating ownership of a foreign account.
The president proposes to require individuals to disclose more information about foreign accounts on their tax returns and to add a penalty targeted at failure to make the tax return disclosure. The proposal would require a U.S. citizen or resident to include an information return with his or her tax return if (1) he or she has an interest in a foreign financial account or entity or holds as an investment a financial instrument or contract issued by a foreign person and (2) the aggregate value of all such items exceeds $50,000. The information return would require disclosure of detailed information about the interests, instruments, or contracts. The penalty for failing to file an accurate and complete return would be $10,000, the same as the penalty for failing to file the FBAR, but the IRS would be required to waive the penalty for an individual showing reasonable cause for a failure.
This proposal seems intended primarily to eliminate an awkwardness about the FBAR. Although the IRS administers the FBAR program, the FBAR is required by a statute outside the Internal Revenue Code and is filed separately from tax returns. As a consequence, a taxpayer’s FBAR filings may not be readily accessible to tax auditors, and the IRS cannot use tax collection procedures to collect the FBAR penalty. The purpose of the proposal is to put foreign account disclosures more squarely into the tax assessment and collection process.
Accuracy-related penalty on underpayments attributable to undisclosed foreign financial assets. Current law imposes an accuracy-related penalty on a taxpayer whose return underreports tax liability if the underpayment is, for example, a substantial understatement of tax (as defined). The penalty, usually 20 percent of the underpayment, is generally imposed without regard to fault, but a taxpayer can escape the penalty by showing reasonable cause for an underpayment. Although the existing penalty can apply to an underpayment resulting from not reporting income from foreign bank accounts, the president proposes to expand the penalty to cover any understatement attributable to undisclosed foreign financial assets and double the penalty rate to 40 percent for such an understatement. The bite of this proposal lies mostly in the doubling of the penalty.
Extended statute of limitations for omissions of income from foreign financial assets. The IRS generally has three years after a taxpayer files a return to assess a deficiency in tax. This period is extended to six years if a taxpayer omits more than 25 percent of his or her gross income, and no statute of limitations applies to a taxpayer filing a fraudulent return. The president proposes a new six-year statute of limitation for a tax deficiency resulting from a taxpayer’s omission of more than $5,000 of gross income from foreign financial assets that the taxpayer failed to disclose as required under a proposal described above or that the taxpayer would be required to disclose but for the $50,000 threshold on the disclosure obligation. Also, if the taxpayer fails to include the disclosure with his or her return, the limitations period would not begin to run until the disclosure is filed.
Reporting of transfers to or from foreign financial accounts. The current FBAR requirements and the proposed tax return disclosures described above are annual reports on interests in foreign financial accounts. The president proposes to add a requirement to disclose transfers to and from those accounts. The proposal would generally require a U.S. citizen or resident to include with his or her income tax return a disclosure of all transfers of money or property that he or she made during the year to foreign bank, brokerage, or other financial accounts and any receipt of money or property from such an account. If a U.S. citizen or resident owns more than 25 percent of an entity that made or received such a transfer, the entity would be required to disclose the transfer. These requirements would only apply for a particular year if either the cumulative amount or value of transfers made or the cumulative amount or value of receipts was at least $50,000. An individual failing to comply with the requirements would generally be liable for a penalty of $10,000 for each unreported transfer or, if less, 10 percent of the cumulative amount or value of the unreported transfers, but the penalty would be waived for an individual showing reasonable cause for all failures.
The proposal would require a U.S. financial institution to report any such transfer that it makes or receives on behalf of a U.S. citizen or resident if the aggregate of the transfers made or received in the individual’s behalf exceed $50,000 during a calendar year. A U.S. financial institution would also have to make this report if it made or received transfers exceeding $50,000 on behalf of an entity if a U.S. individual owns more than 25 percent of the entity. A U.S. financial institution would have to report opening a foreign bank, brokerage, or other financial account on behalf of a U.S. individual or such an entity.
These proposals would apply to transfers made after 2012.
Proposals affecting foreign trusts and their grantors, beneficiaries, and trustees. Under current law, a U.S. citizen transferring property to a foreign trust (a U.S. grantor) is treated as owner of the trust, and is hence taxed currently on its income, if at least one of the trust’s beneficiaries is a U.S. citizen or resident. The president proposes an amendment under which a trust that has received property from a U.S. grantor would be deemed to have a U.S. beneficiary for a taxable year unless the grantor demonstrates in an annual information return that no U.S. citizen could benefit from the trust during the year.
Under current law, a foreign trust’s loan of cash or marketable securities to a U.S. grantor or beneficiary of the trust is treated as a distribution to the grantor or beneficiary. The proposals would extend this rule to apply to a grantor’s or beneficiary’s use of trust assets other than cash or marketable securities.
Current law requires the filing of information returns on foreign trusts. The penalty for failing to file these returns is generally 35 percent of the reportable amounts, but the IRS often discovers the existence of foreign trusts from sources containing no information about the assets and income of the trusts. The proposals would restate the penalty as the greater of $10,000 or 35 percent of the reportable amounts, with the understanding that the IRS would impose the $10,000 amount when it is unable to ascertain the reportable amounts.
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